Intrinsic Value, Part 4: Calculating Free Cash Flow to the Firm
Time to open the financial statements and start building.
In Part 3, we established that for most companies — manufacturers, retailers, technology firms, healthcare companies — the right measure of free cash flow is Free Cash Flow to the Firm, or FCFF. It captures the cash the entire business generates, before any of it is paid to lenders or shareholders.
In this post, we’re going to calculate it.
I’ll show you exactly where each number comes from, what it means, and how to assemble it into a single figure. By the end, you’ll understand not just the formula but the reasoning behind it — why these particular numbers, pulled from these particular places, tell you something real about what a business is worth.
The Three Financial Statements
Every public company is required to publish three financial statements — a standardized set of reports that describe the health and performance of the business. They are:
The Income Statement — shows what the company earned and spent over a period of time (usually a quarter or a full year). It tells you about revenue, costs, and the profit that remained after expenses.
The Balance Sheet — a snapshot of what the company owns and owes at a single point in time. Assets are everything the company owns or controls that has economic value — cash, inventory, equipment, property. Liabilities are everything the company owes to others — loans, unpaid bills, deferred revenue. Equity is what’s left over for the owners once all liabilities are subtracted from assets; it’s the shareholders’ stake in the business. Assets on one side, liabilities and equity on the other. It tells you about the structure of the business — how it’s financed and what resources it has.
The Cash Flow Statement — tracks the actual movement of cash in and out of the business over a period of time. This is different from the income statement, which records revenue and expenses on an accounting basis regardless of when cash actually changes hands. The cash flow statement cuts through all of that and shows you the real money.
We’re going to pull FCFF from all three. Here’s the formula we’re building toward:
FCFF = EBIAT − CapEx + D&A − Change in Working Capital
Four components. Let’s take them one at a time.
Component 1: EBIAT — Earnings Before Interest, After Tax
(From the Income Statement)
EBIAT stands for Earnings Before Interest and After Tax. It answers a simple question: how much operating profit did this business generate, after paying its taxes, but before paying its lenders?
We use EBIT — Earnings Before Interest and Taxes — as our starting point. EBIT is the company’s operating profit: revenue minus all the costs of running the business, but before the interest payments on debt and before income taxes. Operating costs are everything it takes to run the business day to day — salaries, rent, raw materials, utilities, marketing, and the depreciation on equipment. Everything except interest payments and taxes.
EBIT = Revenue − Operating Costs
You’ll find EBIT (sometimes labeled “Operating Income”) on the income statement.
Then we convert it to after-tax:
EBIAT = EBIT × (1 − Tax Rate)
Why do we use EBIT and not net income? Because we want to measure the earnings power of the business itself, independent of how it’s financed. A company with a lot of debt will have large interest payments, which would reduce net income significantly — but that’s a financing decision, not a measure of how well the business operates. We’ll account for the debt separately, at the end of the valuation. For now, we want a clean picture of what the business earns on its own.
Example: Suppose Maple Ridge Manufacturing has EBIT of $50 million and pays an effective tax rate of 25%.
EBIAT = $50M × (1 − 0.25) = $50M × 0.75 = $37.5 million
Component 2: Capital Expenditures (CapEx)
(From the Cash Flow Statement)
Capital expenditures — CapEx — are the investments a company makes in long-lived physical assets: property, plants, equipment, machinery. Think of it as the money a business spends to maintain and expand its capacity to operate.
CapEx is a cash outflow, so it reduces free cash flow. We subtract it.
You’ll find CapEx on the cash flow statement, in the “investing activities” section. Financial data services often report it as a negative number (an outflow), so we take the absolute value.
One important detail: instead of using a single year’s CapEx, we average the last five years. CapEx can swing dramatically from year to year — a company might build a new factory this year and spend almost nothing the next. A five-year average gives a smoother, more representative picture of what the business typically invests.
Example: Maple Ridge’s last five years of CapEx were $8M, $12M, $9M, $11M, and $10M.
Average CapEx = ($8M + $12M + $9M + $11M + $10M) ÷ 5 = $10 million
Component 3: Depreciation and Amortization (D&A)
(From the Cash Flow Statement)
Depreciation and Amortization — D&A — is the accounting charge that spreads the cost of a long-lived asset over its useful life. When a company buys a $10 million machine expected to last ten years, accounting rules don’t let it expense the full $10 million in year one. Instead, it records $1 million per year as a depreciation charge.
This matters for our calculation because D&A is a non-cash expense. It reduces reported profit on the income statement, but no cash actually leaves the building when the depreciation charge is recorded. The cash left when the company bought the machine.
Since we’re trying to measure real cash flow — not accounting profit — we add D&A back.
FCFF = EBIAT − CapEx + D&A − ...
Think of it this way: the company already spent the cash on the asset. Deducting CapEx captures that investment directly. D&A is just an accounting echo of spending that already happened, so we add it back to avoid double-counting.
You’ll find D&A in the “operating activities” section of the cash flow statement.
Example: Maple Ridge records $8 million in D&A this year.
Component 4: Change in Working Capital
(From the Balance Sheet — two periods)
Working capital is the difference between a company’s short-term assets and its short-term liabilities. More precisely, we use non-cash working capital (NWC) — current assets minus cash, less current liabilities minus short-term debt.
NWC (Non-Cash Working Capital) = (Current Assets − Cash) − (Current Liabilities − Short-Term Debt)
The change in NWC from one year to the next tells us whether the business tied up more cash in its day-to-day operations, or released cash from them.
When a company grows, it typically needs to carry more inventory and is owed more by customers (accounts receivable). That’s cash the business is sitting on but can’t use — it’s locked up in the operating cycle. An increase in working capital is a cash outflow, so we subtract it.
Conversely, if working capital falls — say, the company collects receivables faster or convinces suppliers to wait longer for payment — that’s cash being freed up. A decrease is a cash inflow.
Change in NWC = NWC this year − NWC last year
If this number is positive (working capital grew), we subtract it. If negative (working capital shrank), subtracting a negative adds it back — which is correct.
Example: Maple Ridge’s non-cash working capital was $22 million last year and is $25 million this year.
Change in NWC = $25M − $22M = $3 million (an outflow — the business tied up $3M more)
Assembling the Formula
Now we put the four pieces together:
FCFF = EBIAT − CapEx + D&A − Change in NWC
Using our Maple Ridge numbers:
EBIAT = $37.5M
CapEx = −$10.0M
D&A = + $8.0M
Change in NWC = − $3.0M
FCFF = $37.5M − $10.0M + $8.0M − $3.0M = $32.5 million
Maple Ridge Manufacturing generated $32.5 million in free cash flow to the firm this year.
That is the number we will project forward for the next five years, grow it at the rate the business earns on its reinvestment, and then discount each year’s projection back to today using the cost of capital. Add those up, tack on a terminal value for everything beyond year five, and you have the intrinsic value of the firm.
But first we need two more pieces: a growth rate and a discount rate. Those are the subjects of the next two posts.
The One-Sentence Summary
FCFF is what’s left after a business pays its taxes, funds its capital investments, adds back non-cash depreciation charges, and accounts for the cash consumed or released by working capital — the real cash available to all providers of capital.
Next: Part 5 — Where the Growth Rate Comes From. We don’t guess at growth. We derive it from two things the company actually reports: how much it reinvests, and what it earns on those investments.
— Jim